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Wall Street bets on change in Brazil, but the gradual kind

RIO DE JANEIRO (Reuters) - Brazil's financial markets have soared over the past month on hopes that the government may run smaller deficits, stop interfering as much in the private sector and perhaps even undertake long-needed reforms to revive the economy.

But some of the most experienced Brazil-watchers on Wall Street are saying: Not so fast, guys.

While the business climate is likely to improve somewhat in the next few years, hopes for a truly dramatic changes such as an overhaul of the public pension system are probably overdone, they say.

The markets' optimism has centered around an October presidential election in which left-leaning President Dilma Rousseff, who seeks a second term, has been losing popularity among voters.

Rousseff has been unpopular with financial markets because of her heavy hand in the economy. She has alternately cut and raised taxes in various sectors and held down fuel prices at state-run oil company Petroleo Brasileiro SA , among other moves.

Rousseff's two main presidential election rivals are more market-friendly so an opposition win would be welcomed by investors.

Even if Rousseff wins, as she is still expected to do, many investors believe she has been chastened by her falling approval ratings and economic growth averaging just 2 percent a year during her first term, and that could lead her to be less activist in a second term.

A new-look Rousseff would please financial markets if she is "very decisive in the first three months of her new administration to tackle the (macroeconomic) problem," said Paulo Vieira da Cunha, head of research at ICE Canyon, a fund manager with $4 billion (2.37 billion pounds) in assets.

That would probably involve stricter control of government spending and a clear move away from the accounting tricks that Rousseff's government used to meet deficit targets in recent years, most analysts say.

That would allow the economy to move closer to its long-term growth rate of around 3 percent a year, Vieira da Cunha, who was deputy governor of Brazil's central bank between 2006 and 2008, told Reuters in an interview in New York.

"Once you regain a platform of macro stability," he said, "you can start thinking: what can I do to make things grow above that?"

That's where things get complicated.

Relaxing labour laws, attacking pension deficits and overhauling one of the world's most complex tax codes are crucial for Brazil to lay the ground for sustained growth rates of above 4 percent a year, they say.

But those items have been on Wall Street's wish list for a decade or more, with no luck.

While China, Mexico and some other emerging markets have embraced tough reforms to boost long-term growth, Brazil moves slowly.

"The same issues around the reform agenda that I've heard when I started covering Brazil (in 1999) are still there," said Lisa Schineller, director of sovereign ratings at Standard & Poor's.

LITTLE CONFIDENCE, LOW GROWTH

Before Rousseff took office in 2011, she told Reuters in an interview that she believed Brazil's economy could continue to post strong growth without major tax or fiscal reforms.

She is still unconvinced such big changes are necessary or politically feasible, officials close to her say.

Even if one of her more market-friendly rivals wins, he would likely have to deal with the same deadlocked, hostile Congress that has stymied Rousseff.

Many legislators point to last decade's robust growth as proof that Brazil's economy does not need major changes. They believe the recent slowdown is more the result of international issues, like China's slowdown and debt problems in Europe.

As a result, most of the reforms championed by investors are barely in the discussion phase.

"You have to debate those reforms for three years and the discussion is not there," said Sebastian Briozzo, another director of sovereign ratings at S&P.

Lack of progress on reforms was at the root of S&P's decision to downgrade Brazil's ratings to near junk level last month. Prospects for meaningful reforms in the next few years are also slim, according to the ratings firm.

The stagnation has led to falling corporate confidence and lower investment throughout Rousseff's term. But sentiment may have recently bottomed out, said Ben Rozin, senior analyst and portfolio manager with Manning & Napier, a Rochester, New York-based fund manager with $48 billion in assets.

Brazil's stocks tumbled 15 percent last year - the worst performance among the world's 50 largest equity markets.

Like many Wall Street investors, Manning & Nappier sharply reduced its holdings of Brazilian shares during the first years of Rousseff's administration.

Since then, it has been wading back into the Brazilian market as stock prices looked attractive.

Meanwhile, recent polls showed Brazilians, worried about a pick up in inflation, are growing less supportive of Rousseff's economic policies. Bets on some kind of positive political change contributed to a nearly 16 percent jump in the benchmark Bovespa index <.BVSP> since March 14.

Rousseff still remains a favourite to win the election. Many investors say they have a model for what the rest of her presidency could look like - her predecessor, Luiz Inacio Lula da Silva, who was from the same leftist party but was perceived as a significantly steadier hand.

"We're hopeful that, even if there is no change in leadership, perhaps the second administration of Dilma will be closer to what Lula had: with less intervention and more business-friendly policies that benefit everyone," said Rozin.